How are stock options taxed and reported?

Key takeaways

• Stock options give you the right to buy or sell a stock at a specified price by a certain date.
• Incentive stock options (ISOs) are a special type of stock option given to employees as part of their compensation.
• Non-qualified stock options (NSOs) are a type of stock option that companies can offer not only to employees but also to directors, contractors, and others.
• Exercising stock options means purchasing the company's stock at the exercise price.
• Once you own the stock, you can sell it at any time. The timing of your sale affects how the profit is taxed.
• You’ll need IRS Form 3921 from your employer to report the exercise of ISOs.

What are stock options?

Stock options give you (the holder) the right to buy or sell a stock at a specified price (known as the exercise or strike price) by a certain date. This allows you to purchase the stock at the set price, even if the market price is higher than the exercise price. The two main types of stock options are incentive stock options (ISOs) and non-qualified stock options (NSOs).

What are incentive stock options (ISOs)?

ISOs are a special type of stock option given to employees as part of their compensation, and they come with great tax benefits. When you exercise these options, you don’t have to pay regular income tax right away.

If you keep the stock for at least a year after exercising and two years after the grant date, your profit is taxed at the lower long-term capital gains rate. This means you'll pay less in taxes on the gains from selling the stock than from your normal income.

However, exercising ISOs can trigger the Alternative Minimum Tax (AMT), which is a separate tax system that ensures high-income taxpayers pay a minimum portion of their income in income taxes. It’s important to plan ahead and possibly consult with a Tax Pro to make the most of your ISOs and avoid unexpected taxes.

What are non-qualified stock options (NSOs)?

NSOs are a type of stock option that companies can offer not only to employees but to directors, contractors, and others. They don't have the same tax benefits as ISOs, but they are available to more people.

NSOs allow you to buy company stock at a fixed price that’s usually set at the market price when the options are granted. They typically come with a vesting schedule, which means that you gain the right to exercise the options over time, and an expiration date, often 10 years from the grant date.

When you exercise NSOs, the difference between the exercise price and the market value of the stock is considered ordinary income and is subject to income tax, as well as Social Security and Medicare taxes. This income will appear on your W-2 form if you’re an employee.

When you sell the stock, any additional gain is taxed as a capital gain. Selling within a year of exercising results in a short-term capital gain, taxed at your regular income tax rate, while holding the stock for more than a year results in a long-term capital gain, which typically has a lower tax rate.

Exercising options

Exercising stock options means purchasing the company's stock at the exercise price. For example, if your stock option gives you the right to buy shares at $20 each, and the current market price is $50, you can still buy them for $20. The difference between the market price and the exercise price is your potential gain.

When you decide to exercise your options, you might pay cash to buy the shares. In some cases, you might have the option to do a cashless exercise, where you use some of the shares you're buying to cover the cost.

Selling stocks after exercise and reporting

Once you own the stock, you can sell it at any time. The timing of your sale affects how the profit is taxed. If you sell the stock immediately after exercising the options, the difference between the exercise price and the sale price is typically considered ordinary income, which is taxed like your salary. If you hold onto the stock for a longer period before selling, the profit might be taxed as a capital gain.

When it comes to tax time, reporting stock options can be a bit complex. For ISOs, you receive a special form called Form 3921 from your employer, which we’ll cover later. You’ll also need to include any gains on your tax return.

For NSOs, the process is a bit different. When you exercise these options, the difference between the exercise price and the fair market value at the time is considered income and will appear on your W-2 form. It’s subject to income tax and Social Security and Medicare taxes.

How are stock options taxed?

Understanding how stock options are taxed can help you make the most of this benefit while avoiding surprises at tax time. Let’s break down the tax treatment for the two main types of stock options, ISOs and NSOs.

How ISOs are taxed

• At exercise: When you exercise ISOs, you don’t owe regular income tax. However, the difference between the exercise price and the fair market value of the stock at the time of exercise is considered a preference item for the AMT. This means you might have to pay AMT if this amount is large enough.
• At sale: The taxation depends on how long you hold the stock after exercising the options.
  • Qualifying disposition: If you hold the stock for at least one year after exercising and two years from the grant date, any profit you make when selling the stock is taxed as a long-term capital gain, which typically has a lower tax rate.
  • Disqualifying disposition: If you sell the stock before meeting these holding periods, the difference between the exercise price and the market value at the time of exercise is taxed as ordinary income. Any additional gain is treated as a capital gain (short-term or long-term, depending on how long you held the stock).

IRS Form 3921, Exercise of an Incentive Stock Option

You’ll need IRS Form 3921 from your employer to report the exercise of ISOs. It includes important details about your stock option exercise, such as the date you were granted the option, the date you exercised it, the exercise price, and the fair market value of the stock at the time of exercise.

The information on Form 3921 helps you accurately report your stock option exercise on your tax return. Keep Form 3921 as proof of the details of your ISO exercise.

How NSOs are taxed

• At exercise: When you exercise NSOs, the difference between the exercise price and the fair market value of the stock at that time is considered ordinary income. This amount is included in your wages and is subject to income tax, as well as Social Security and Medicare taxes. It will be reported on your W-2 form.
• At sale: The timing of your sale affects the tax treatment:
  • Short-term capital gains: If you sell the stock within a year of exercising the options, any profit you make is taxed as a short-term capital gain, which is taxed at the same rate as ordinary income.
  • Long-term capital gains: If you hold the stock for more than a year before selling, any profit is taxed as a long-term capital gain, which generally has a lower tax rate.

Stock options can be a powerful part of your compensation. Whether you have ISOs or NSOs, understanding how they work and their tax implications is important.

Work with a Tax Pro who can answer any questions you have about stock options and how they’re taxed.

About the Author

Mark Steber is Senior Vice President and Chief Tax Information Officer for Jackson Hewitt. With over 30 years of experience, he oversees tax service delivery, quality assurance and tax law adherence. Mark is Jackson Hewitt’s national spokesperson and liaison to the Internal Revenue Service and other government authorities. He is a Certified Public Accountant (CPA), holds registrations in Alabama and Georgia, and is an expert on consumer income taxes including electronic tax and tax data protection.

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